Key Questions: What Are Bonds Good For?
Bonds possess some defensive qualities, but investors should be mindful of over-diversifying and over-liquifying their portfolios.
Looking back on my career, I consider myself extremely lucky to have met many amazing people. Some are well known, and a few are people I would go so far as to characterize as legends. But most of these remarkable individuals come across as ordinary based on their appearance, the way they carry themselves, or the candor with which they speak. Optimism and humility are common traits as well.
One particular individual was a lifetime trustee of several venerable institutions, including one where I worked. Because of his generosity to that institution and prominence in the community, I gladly and frequently accepted invitations to visit with him. He was always cordial, inquisitive, generous with his time, and incredibly modest when discussing his family’s accomplishments. He also urged me to call him by his first name, David.
During one of our visits, David introduced me to his eldest son, who, after much coaxing from his proud father, humbly spoke of meeting with Steve Jobs (founder of Apple, Inc.), where he presented one of his inventions that he affectionally referred to as “Siri.” During another meeting, David recalled his investment decades earlier in a startup company that would grow to become Amgen, one of today’s largest biotechnology companies. “That one turned out pretty well,” I remember him saying.
At some of our early meetings, David would ask me to describe how I was investing on behalf of the institution. “We are well-diversified,” I usually answered. “Do you own any bonds?” he often countered.
"Why, yes,” I replied. “What are bonds good for?” David asked somewhat impatiently. “Bonds serve as an important ballast within the portfolio. They help diversify our equity risk and provide us with some amount of income that we can redeploy or reinvest,” I explained.
As he processed my response, his brow furled, and a small scowl grew on his face. Then, after pausing, David told me something I will never forget: “Bonds are for wusses!” he barked. “The only sure way to generate wealth is to own equities — lots of them and of every kind,” he exhorted.
Despite his advanced age (he was nearly 90 when I met him), David never owned a single bond or fixed income asset in his portfolio, I would later learn. Almost 100% of his assets were in individual equities, limited partnerships, or other equity-oriented vehicles. “Based on my asset allocation, my portfolio is one of the most aggressive portfolios within my advisor’s firm,” he would say with satisfaction.
David’s dislike for bonds might strike some as being unconventional. But as I reflect on our conversations, perhaps it was appropriate given his modest need for income: He had no issues with selling appreciated stocks to fund his lifestyle/cash flow needs. “Paying capital gains taxes is an indicator of success,” he once quipped.
Too, while fully aware of his age, David also had a long time horizon as he believed that his portfolio was truly perpetual in nature, meaning that he expected it to outlive him. Furthermore, David felt he could not only withstand short-term market fluctuations but often viewed them as buying opportunities because of his inherent optimism and belief in innovation.
David passed away five years ago this spring. However, were he alive today, I have no doubt that his aversion to fixed income would be just as intense as the current fixed income environment has become even less attractive given the preponderance of negative real yields (yields after inflation). This approach almost assures lower prospective returns. Moreover, given their low starting yields today, bonds offer lesser amounts of diversification benefits than they did in the past. And should inflation pressures continue to build and interest rates rise further, losses (on paper at least) may result.
For these reasons, we recommend an overweight to risk assets such as equities relative to safe havens such as fixed income. This is a deliberate tactical tilt relative to one’s strategic (i.e., longer-term) asset allocation strategy, which is created to properly align one’s portfolio with her/ his investment objectives.
Given the above-referenced fixed income backdrop, however, I think it may be worth revisiting one’s strategic asset mix as well and consider a measured reduction in bonds. This is not to suggest that equity-market risk has been eliminated or diminished. If anything, given lofty valuations for equities in general (and some areas of the market in particular), coupled with the still unevenness and uncertainty of the strength of the economic recovery, stocks are susceptible to pullbacks.
Additionally, despite the headwinds of lower yields/income and lower prospective returns, bonds still can provide an important element of preservation within a well-diversified portfolio. Moreover, given the global bond market’s massive size, opportunities are ripe for shrewd and disciplined active management. In my view, this is something that plays to our firm’s strengths.
Still, some investors may have over-diversified or over-liquified their portfolios by owning too much fixed income or holding too much cash. We will elaborate on these points in greater detail in future publications. But for the time being, most investors should employ modest tilts toward equities emphasizing quality securities, incorporate real asset and absolute return strategies where appropriate, and own bonds for defensive reasons. That is what bonds are good for.
For more information, please contact your Key Private Bank Advisor.